Kinder Morgan: the $100M warrant buyback approval is bullish

·         Kinder Morgan board of directors just approved a $100M warrant repurchase program.

·         Management is signaling confidence that the common would trade above $42.79 when warrants expire.

·         The total return at that price-level is projected at ~20%, a decent outcome.

On June 12, 2015, Kinder Morgan filed a regulatory 8K report disclosing board approval for a $100M warrant repurchase program. This is a notable about-turn as in the Q4 2014 earnings call on January 22, 2015, Richard Kinder said the following in reply to an analyst question about whether the company is considering stock or warrant buybacks in the open market:

“No, that’s not in our present plans. Again, what we have said is that we’re going to concentrate on this tremendous dividend growth story that we’ve got and be very careful about maintaining our investment grade rating by keeping -- by paying close attention to and keeping that debt to EBITDA in the range that we have talked about over the last six months.”

These warrants were issued in May 2012 as part of the El Paso acquisition. At the time, 505M warrants (5-year term, Exercise Price $40) were issued and they were valued at $863M ($1.71 per warrant). As of Q1 2015, the outstanding warrant count is at 289M shares: ~43% reduction primarily through periodic repurchases. The repurchase activity over that timeframe follows:

*** The warrants remaining do not tally because of conversion of certain preferred shares and exercise activity.

*** $98M, $465M, and $157M worth of warrants were repurchased in 2014, 2013, and 2012 respectively.

*** In addition, repurchase activity included the following in the common during the timeframe: $94M and $172M worth of class P shares in 2014 and 2013 respectively.

The cost of the warrants to the business would be zero, if the stock trades below $40 (assuming no adjustment to the exercise price) at expiry. Otherwise, the cost would be the price-premium above $40 per share multiplied by the warrants outstanding. For example, if at expiry there are 250M warrants outstanding and the stock trades at $45, the cost of the warrants to the business would be $1.25B. The present value of that future cost will be $1.13B at a 5% interest rate. If management confidence level is high for the stock to trade above $45 at expiry, it would then make sense to repurchase the warrants, as long as the cost is below $1.13B or $4.54 per warrant outstanding.

Below is a look at implied management confidence level for the stock price at expiry based on the average price paid per warrant on the buybacks so far:

The confidence level has been in the $41.50 to $45 price-range throughout. Currently, the warrants are trading at $3.08 and assuming management follows through and buys back at ~$3 average-price, the confidence level for the share price at expiry is $42.79. That is a modest ~8.7% increase from the current price. Adding the $4.50 in dividends projected will bring the total return to ~20.2%.

KMI is a relatively stable dividend growth stock with a high initial dividend yield of ~5% and expected return of at-least ~10% per year for the next two years. As such, it is a good fit for income portions of diversified investment portfolios.